TALLER II Tema: Comunicación

The banking sector is one of the most heavily regulated sectors of the economy, due in large part to the important role of banks in facilitating credit and economic growth. Global regulators continue to emphasise the importance of capital regulation to ensure that banks hold a minimum level of capital to cushion against unexpected losses and adverse shocks which could result in bank failure. Recent widespread problems in global financial markets and banking sectors have raised concerns over the design and role that capital regulation plays in influencing bank behaviour and the market perception of bank risk (Francis and Osborne, 2010).

In Australia, banks have, for the most part, avoided the recent turmoil experienced by overseas financial markets, reflecting good regulation and economic management, as well as some good fortune (Davis and Brown, 2008). An International Monetary Fund (IMF) review found the Australian banking system has been resilient and well managed (IMF, 2012, p.5). As explained in Chapter 4, the regulatory body for the banking sector, the Australian Prudential Regulation Authority (APRA) exhibits a high degree of compliance with international standards, maintaining a conservative supervisory approach34. Australian banks have been consistently well capitalised, holding average tier 1 and total regulatory capital

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For example, APRA has already required Australian banks to hold 75% of tier 1 capital as the higher quality fundamental tier 1 capital, which is higher in quality and closely related to the new Basel III guidelines for common equity tier 1 capital. In addition, an LGD floor of 20% is imposed for residential mortgages, higher than the Basel II requirement. APRA is intending to keep a conservative stance in adopting Basel III.

ratios of 9.51% and 12.39% respectively over the sample period examined in this study. These levels are well above global regulatory minima35. However, much less is known about the way risk-based capital regulation affects the regulatory capital ratios held by Australian banks. This study provides insights into this relationship in the context of the Australian banking sector.

Existing literature demonstrates that banks have an incentive to target a level of capital above the regulatory minimum, a so called ‘capital buffer’ (Marcus, 1984; Milne and Whalley, 2001; Milne, 2004). The literature finds banks hold capital buffers as insurance against costly supervisory action in the event of unexpected events causing the capital ratio to fall below the regulatory minimum. Other reasons for holding capital buffers identified by past literature include: market discipline, to target an external credit rating, to weather economic downturns, to secure access to wholesale deposits and money markets, and for long-term growth and acquisition strategies (Berger et al, 1995; Ayuso et al, 2004; Lindquist, 2004; Stolz and Wedow, 2005; Jokipii and Milne, 2008).

The issue of what determines bank capital ratios has become increasingly important. Global regulatory authorities are interested in identifying potential threats and problems in the banking system. A better understanding of the determinants and reasons for holding capital buffers allows authorities to evaluate regulatory intervention and future responses to banking problems (Francis and Osborne, 2010). To date there is scarce empirical literature investigating these areas in the Australian banking system.

35 _{Global regulatory minimum requirements are those imposed under the Basel I and Basel II frameworks of 4}

In Australia, APRA imposes individual capital requirements for authorised deposit-taking institutions (ADI’s)36, known as prudential capital ratios (PCRs) as part of prudential standards for capital adequacy. In assessing an ADI’s overall capital adequacy, APRA may take into account additional risk factors to ensure minimum requirements are consistent with its overall risk profile. The PCR imposed on an ADI is never lower than the Basel minimum requirement. PCRs have been in force since January 2008 under Basel II, however elevated regulatory capital requirements could be enforced by supervisors prior to this, under the Basel I framework37.

From a long-term perspective, theoretical literature reaches common conclusions regarding the way in which bank capital ratios respond to changes in underlying capital regulation. Thus theoretically, increases in capital requirements should increase bank capital both in absolute terms and relative to bank lending (VanHoose, 2008; Shrieves and Dahl, 1992). These findings have led to a considerable amount of empirical research (Van Roy, 2005; Barrios and Blanco, 2003; Beatty and Gron, 2001; Furfine, 2001; Jackson et al, 1999), with contrasting conclusions. To date, there is no such empirical literature in the context of the Australian banking sector. This study is the first to examine the efficacy of PCRs in influencing Australian bank capital management practices.

From a short-term perspective, past literature predicts that increased capital requirements should have the potential adverse effect of reducing individual bank lending and increasing equilibrium loan rates (Goodhart et al, 2004; Borio, 2003; Catarieneu-Rabell et al, 2005;

36 _{An ADI is defined by APRA as a corporation which is authorised under the Banking Act 1959 to take}

deposits from customers. ADIs include banks, building societies and credit unions. All ADIs are subject to the same prudential standards imposed by APRA, but for the corporation to use the word ‘bank’, ‘building society’ and ‘credit union’ in its name, it must meet certain criteria.

37 _{For the purposes of this paper, the term PCR is used to refer to the bank specific minimum capital requirement}

Estrella, 2004). This has led to a number of empirical studies examining the extent to which risk-based capital regulation is procyclical (Ayuso, 2004; Lindquist, 2004; Stolz and Wedow, 2011; Francis and Osborne, 2010; Coffinet et al, 2012; Shim, 2012), with conflicting findings. The term procyclical here refers to the extent to which banks’ capital management practice amplifies economic cycles. A key objective of such capital regulation is risk- sensitivity, particularly under the Basel II Framework, attempting to more accurately align banks capital requirements with the riskiness of their exposures.

If banks are short-sighted in their capital management practices, an accumulation of risky exposures during expansions when risk-based capital requirements are low can result in considerable loss once a downturn in the business cycle sets in. During a downturn, when risk-based capital requirements increase, difficulty in raising capital may result in the need for banks to restrict lending considerably to meet a targeted optimal capital ratio. Such restricted bank lending has unfavourable consequences for the real economy, reducing output further and causing a longer and more pronounced downturn.

In response, the BCBS has advocated that banks should build up countercyclical capital buffers in good times in order to draw down on these surpluses in bad times (BCBS 2012). This has led prudential standards in Australia to impose a countercyclical capital buffer in addition to minimum capital requirements as part of the Basel III framework (APS 110, 2013)38. As a secondary objective, this paper contributes to the literature by testing the extent to which Australian banks’ capital management practices are procyclical. No prior research has examined this issue in the context of the Australian banking sector. As a result, this study

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The new regime requires banks to accumulate extra capital above regulatory minimum requirements that can be used during periods of stress. The new countercyclical capital buffer has a range of 0-2.5% of common equity tier 1 capital, designed to dilute lending bubbles by requiring banks to increase capital during upturns. These requirements are due to be implemented by APRA from 1 January, 2016.

provides insights relevant to determining the efficacy of prudential standards in implementing countercyclical buffer requirements in Australia.

This study uses a privately reported regulatory dataset to investigate three previously unexamined questions in the Australian banking system over the sample period 2004 to 2012 with regard to the behaviour and determinants of capital buffers. Firstly, do Australian banks target a level of capital above the Basel imposed minimum risk-weighted capital ratio? Secondly, what determines the level of capital buffers held by Australian banks? And finally, what is the impact of bank-specific prudential capital ratios (PCRs) on Australian bank capital buffers?

The findings of this study suggest that Australian banks hold a targeted level of capital with quarterly speed of adjustment coefficients of 19 and 15 per cent for total and Tier 1 capital ratios respectively. Findings suggest bank risk and size are negatively related to capital buffers with ROE being positively related, and that the implementation of Basel II has had a positive impact on the capital buffers banks hold. Findings suggest a positive relationship between the business cycle and Australian bank capital buffers, interpreted as a countercyclical effect. Finally, results indicate banks respond to increases in bank-specific regulatory imposed PCRs by increasing regulatory capital ratios, indicating their effectiveness in influencing banks’ capital management practices.